The US-Iran conflict reignites "inflation concerns": soaring oil prices could increase US inflation by 0.7%. Can the Federal Reserve still cut interest rates?

The U.S. and Israel’s strikes on Iran pushed oil prices higher, pulling U.S. inflation pressures, which had recently eased, back into market focus. If the oil shock develops into a sustained supply disruption, inflation may struggle to decline, and the Federal Reserve’s room to cut interest rates will also shrink.

On March 3, Brent crude oil hit $85 per barrel for the first time since July 2024, rising 9% intraday. Diesel and gasoline futures also climbed. Previously, amid relatively sticky costs like food, U.S. consumers could buffer some inflation with cheaper gasoline, but this support is now weakening.

Inflation-wise, the U.S. CPI in January rose 2.4% year-over-year, cooling from 2.7% in December, partly thanks to a 7.5% YoY drop in gasoline prices. However, if crude oil prices stay high, gasoline prices could transmit to consumers within weeks, further raising transportation and airfare costs, and expanding their impact on overall price levels.

Neil Shearing, Chief Economist at Capital Economics, estimates that if oil prices stay elevated at $100 per barrel for an extended period, overall inflation could rise by about 0.7 percentage points. For investors, the key variables are the “intensity and duration” of the shock. JPMorgan CEO Jamie Dimon told CNBC on Monday that as long as the strikes don’t drag on, inflation impact will be limited. Trump also said Monday that U.S. actions in Iran are expected to last four to five weeks, “but we have the capacity to sustain longer.”

How Oil Prices Transmit to Inflation: Gas Stations, Transportation Costs, and Airfare

Gasoline prices are highly correlated with inflation because the transmission chain is short, prices update frequently, and competition is fierce. The U.S. Energy Information Administration states that crude oil prices are the single biggest factor determining gas station prices in the U.S.

An often-cited rule of thumb in economics is that a $5 increase in oil prices raises the YoY inflation rate by about 0.1 percentage points. While seemingly small in a single instance, sustained increases can visibly push up prices over time.

Rising oil prices also spill over into other categories. Higher trucking costs for food and goods, and more expensive jet fuel, can push up airfare prices, thereby broadening their impact on overall inflation.

Two Scenarios: Short-term Disruptions Are Limited, but Persistent Rises Raise Inflation “Steps”

Many economists believe that if energy market disruptions are short-lived, inflation may only be elevated for one or two months. Last year’s 12-day conflict between Iran and Israel briefly pushed oil prices up by about $10 at its peak, with energy infrastructure largely unaffected, resulting in a short-term price impact.

Meanwhile, gasoline accounts for a relatively small share of household spending. According to the latest government inflation report, gasoline made up about 3% of the average consumer’s expenditures in December, while food was around 13%, and housing costs exceeded one-third. This means that unless oil prices rise significantly and persist, gasoline alone is unlikely to “drive” inflation over the long term.

However, more intense scenarios are still on the table. Harvard Business School economist Alberto Cavallo notes that if the Iran conflict causes sustained increases in crude oil, the effects could be reflected at gas stations within weeks, raising overall inflation.

Neil Shearing estimates that if oil prices stay high at $100 per barrel for an extended period, overall inflation could increase by about 0.7 percentage points.

Can the Fed Still Cut Rates? Energy Shocks and Existing Price Pressures Raise the Bar

In a scenario where inflation continues to rise, the Federal Reserve may find it harder to “ignore” upward risks from energy. Neil Shearing believes that if inflation is significantly driven higher by oil prices, the Fed will be “less willing” to cut short-term interest rates.

The policy backdrop is not solely about “energy.” This year, with the labor market stabilizing and some price pressures remaining stubborn, the reasons to support further easing by the Fed are diminishing.

If potential energy shocks combine with last year’s tariff hikes still transmitting through the price chain, the Fed may adopt a more cautious stance on rate cuts.

Although the Fed often views energy shocks as short-term disruptions and prefers to “ride it out” rather than react immediately, one of the key reasons it cut rates three times from September to December was the short-term improvement in inflation. If oil prices push inflation higher again, it will raise the threshold for further rate cuts.

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